ESTATE OF DANIEL LEAVITT, DECEASED, ET AL., PETITIONERS V.
COMMISSIONER OF INTERNAL REVENUE
No. 89-280
In The Supreme Court Of The United States
October Term, 1989
On Petition For A Writ Of Certiorari To The United States Court Of
Appeals For The Fourth Circuit
Brief For The Respondent In Opposition
TABLE OF CONTENTS
Question Presented
Opinions below
Jurisdiction
Statement
Argument
Conclusion
OPINIONS BELOW
The opinion of the court of appeals (Pet. App. 1-20) is reported at
875 F.2d 420. The opinion of the Tax Court (Pet. App. 21-71) is
reported at 90 T.C. 206.
JURISDICTION
The judgment of the court of appeals was entered on May 19, 1989.
The petition for a writ of certiorari was filed on August 17, 1989.
The jurisdiction of this Court is invoked under 28 U.S.C. 1254(1).
QUESTION PRESENTED
Whether the shareholders of a Subchapter S corporation increased
their basis in the corporation (and therefore their ability to offset
corporate losses against their income from other sources under 26
U.S.C. 1374(c)(2) (1976)) merely by guaranteeing the corporation's
debt to a bank.
STATEMENT
1. In 1979, Daniel Leavitt /1/ spent $10,000 to purchase shares of
stock in VAFLA Corporation, a Virginia corporation formed earlier that
year to acquire and operate an amusement park near Tampa, Florida.
After its first few months of operation, VAFLA's liabilities exceeded
its assets, and it was unable to meet its cash flow requirements.
Virtually all of the corporation's assets were already encumbered by a
purchase-money mortgage and could not be used as collateral. In
August 1979, Leavitt and six other shareholders signed guarantee
agreements whereby each agreed to be jointly and severally liable for
all of VAFLA's indebtedness to the Bank of Virginia. On September 12,
1979, VAFLA borrowed $300,000 from the Bank of Virginia, giving its
note in return. The bank would not have made the loan without
receiving the shareholders' personal guarantees. Pet. App. 4-5,
24-25.
The bank loan was reflected on VAFLA's financial statements and tax
returns as a loan from the shareholders who had guaranteed the loan.
VAFLA made all of the loan repayments to the bank, however, and the
shareholders were never asked to make good on their guarantees.
Moreover, neither the corporation nor any of the shareholders who had
acted as guarantors treated the corporate payments on the loan as
constructive income to the shareholders. Pet. App. 5. /2/
VAFLA elected to be taxed under the provisions of Subchapter S of
the Internal Revenue Code, Sections 1371 et seq. /3/ Under these
provisions, the income of an electing small business corporation is
not subject to the corporate income tax, but rather is taxed on a pro
rata basis as income to the shareholders. See I.R.C. Sections 1372,
1373. Any net operating loss incurred by a Subchapter S corporation
is similarly passed through to its shareholders, each of whom is
entitled to deduct on his individual return his proportionate share of
the loss (Section 1374(a)) -- subject to a maximum that reflects the
shareholder's investment in the corporation. The shareholder's
deduction for a net operating loss incurred by a Subchapter S
corporation is limited to the sum of (A) the shareholder's adjusted
basis in the corporation's stock and (B) the adjusted basis of any
indebtedness of the corporation to the shareholder (Section
1374(c)(2)).
In its first fiscal year, ended September 30, 1979, VAFLA incurred
a net operating loss in the amount of $265,566 (Pet. App. 4 n.4). On
their joint income tax return for 1979, Daniel and Evelyn Leavitt
claimed a loss of $13,808, based upon the Leavitts' pro rata share of
the corporation's loss. On audit, the Commissioner invoked Section
1374(c)(2) to limit the deduction to $10,000 -- the amount of cash
Leavitt had invested in the corporation, and he accordingly asserted a
deficiency in the Leavitts' income tax for 1979. Pet. App. 26.
2. Petitioners sought redetermination of the asserted deficiency in
the Tax Court, which sustained the deficiency in a reviewed decision
by a 19-1 vote (Pet. App. 21-71). The majority rejected petitioners'
contention that Leavitt's guarantee of VAFLA's debt to the Bank of
Virginia operated to increase the amount of the allowable loss
deduction "cap" imposed by Section 1374(c)(2). The court explained
that Leavitt's basis in his Subchapter S corporation stock was "cost,"
as established by Section 1012 of the Code. His ability to deduct
losses under Section 1374(c)(2)(A) therefore was limited to his actual
out-of-pocket investment in the corporation. Because the guarantees
in the instant case had not involved "an economic outlay or a
realization of income" (Pet. App. 30), the court concluded that the
guarantees did not serve to increase the shareholders' bases in the
corporation. Id. at 30-32.
The Tax Court specifically rejected petitioners' contention that
the bank loan transaction should be recast as a loan from the bank to
the shareholders, followed by contribution of the loan proceeds by the
shareholders to the corporation (a contribution that would have
increased their equity in the corporation) (Pet. App. 33-41). The
court noted that the bank in fact had lent the money to the
corporation, that it had earmarked the loan proceeds for use in the
corporation's business, and that the shareholders were not free to
dispose of the proceeds as they wished. The court further noted that
the corporation's payments on the loan had not been treated as
constructive income to the seven shareholders on either the corporate
or individual returns for the years in issue. Accordingly, the court
concluded that the substance of the bank loan transaction was fully
consistent with its form as a loan to the corporation rather than to
the shareholders. Id. at 33.
Because the shareholders had made no economic outlay at all in
connection with the loan from the bank to the corporation, the court
found it unnecessary to examine the factors usually applied to
determine whether a debt transaction should be regarded as a
contribution to equity. See Pet. App. 33-36 & n.8. Finally, the Tax
Court expressed its disagreement with the Eleventh Circuit's view in
Selfe v. United States, 778 F.2d 769 (1985), that a shareholder's
guarantee of corporate debt can increase his basis if the lender was
looking primarily to the shareholder for repayment (Pet. App. 37-41).
The Tax Court explained that this approach would allow the
shareholders of Subchapter S corporations to avoid the specific
limitation enacted by Congress that restricts the loss deductions of a
Subchapter S shareholder "to the amount he has actually invested in
the corporation" (id. at 38).
Three judges concurred only in the result. Judge Williams filed a
separate opinion, stating that he agreed with the result reached by
the majority but expressing the view that the majority had
"unnecessarily reject(ed)" the reasoning of Selfe (Pet. App. 42-43).
He explained that Selfe had involved a corporation wholly owned by one
shareholder, where "the form of the transaction had no tax
significance" (id. at 42), and he maintained that "the Selfe rationale
can be correctly applied" in certain circumstances, "limited to cases
involving the sole shareholder" (id. at 43).
Judge Fay dissented (Pet. App. 43-71). He argued that the
rationale of Selfe -- namely, "that traditional debt-equity principles
are applicable in determining whether a shareholder-guaranteed
subchapter-S corporate debt should be recharacterized as a capital
contribution" (id. at 49) -- is correct and is fully applicable to
this case. He further concluded that these principles would justify
treating the guarantee here as equity -- i.e., that the corporate bank
debt should be viewed as a loan to the shareholders, followed by their
contribution of the loan proceeds to the corporation -- because the
bank looked to the shareholders for repayment (id. at 61-66). Judge
Fay proceeded to find that this conclusion required recharacterizing
the corporation's loan repayments to the bank as cash distributions to
the shareholders followed by payments by the shareholders of principal
and interest to the bank (id. at 67).
3. The court of appeals affirmed (Pet. App. 1-20). It agreed with
the Tax Court's conclusion that the shareholder guarantees gave rise
to no increase in basis under Section 1374(c)(2), reasoning that
petitioners "have experienced no * * * call as guarantors, have
engaged in no economic outlay, and have suffered no cost" (Pet. App.
7). The court of appeals also declined to recast the bank loan to the
corporation as a loan to the shareholders, followed by their
contribution of the loan proceeds to the corporation. It explained
that "taxpayers are liable for the tax consequences of the transaction
they actually execute and may not reap the benefit of recasting the
transaction into another one substantially different in economic
effect that they might have made" (id. at 9). The court of appeals
found no error in the Tax Court's determination that the substance of
the transaction matched its form of a loan from the bank to VAFLA, not
to the shareholders (id. at 10-11). The court specifically rejected
petitioners' contention that the application of "debt-equity
principles" requires treating the shareholder guarantees as if they
constituted actual contributions to capital. The court explained that
debt-equity principles become relevant only at the second stage of a
two-part inquiry; they assist in classifying actual shareholder
advances as either debt or equity, but furnish no basis for
determining whether there has been an actual outlay in the first
place. Here, where the Tax Court correctly found that the loan was
made directly from the bank to the corporation, there is no occasion
to examine the various debt-equity factors. Id. at 8-14.
The court proceeded to explain that, although it rejected
petitioners' reliance on Selfe, it did not view that case as
compelling a different result here (Pet. App. 14-20), and therefore it
did not "reject the case completely" (id. at 16 n.15). The court
stated that it did not disagree with the result in Selfe, which simply
vacated the entry of summary judgment and remanded for further factual
development, "to the extent that the Selfe court remanded because
material facts existed by which the taxpayer could show that the bank
actually lent the money to (the shareholder) rather than to the
corporation" (id. at 19). The court also stated that, "(t)o the
degree that the Selfe court agreed with Brown (v. Commissioner, 706
F.2d 755 (6th Cir. 1983)) that an economic outlay is required before a
shareholder may increase her basis in a subchapter S corporation,
Selfe does not contradict current law or our resolution of the case
before us" (Pet. App. 19). The court of appeals did reject, however,
"the Selfe court's suggestion that debt-equity principles must be
applied to resolve the question of whether the bank actually lent the
money to the taxpayer/shareholder or the corporation" (id. at 19-20).
ARGUMENT
The court of appeals correctly rejected petitioners' argument that
Daniel Leavitt's and other shareholders' guarantee of a bank loan to
their Subchapter S corporation increased their respective bases in the
corporation's stock, thereby relaxing the limitation on their ability
to offset the corporation's losses against their individual income
from other sources. Moreover, this decision does not create a direct
conflict in the circuits that warrants this Court's intervention.
Accordingly, there is no reason for review by this Court.
1. Section 1374(c)(2) places a specific limitation on the ability
of shareholders to offset the losses of their Subchapter S corporation
against their income from other sources -- keyed to the amount of
their bases in their shares and any amounts that they have lent to the
corporation. In the words of the Senate Report, Section 1374 limits
the amount of the Subchapter S shareholders' deduction of the
corporation's net operating losses "to the adjusted basis of the
shareholder's investment in the corporation." S. Rep. No. 1983, 85th
Cong., 2d Sess. 220 (1958). The obvious intent of the limitation is
to prevent individuals from using Subchapter S corporations as "tax
shelters," i.e., from using corporate losses that exceed their
investment in the corporation to shelter from tax their income from
other sources.
As the courts below held, Section 1374(c)(2) operates to implement
this purpose by limiting a shareholder's deduction of corporate losses
to the amount of his actual economic outlay, thereby precluding
deductions that exceed the amount of the economic loss suffered by the
shareholder. Accordingly, the courts have repeatedly rejected the
contention of Subchapter S shareholders that their personal guarantees
of loans to their corporations operate to relax the Section 1374(c)(2)
limitation by increasing their bases in the corporation's stock. See,
e.g., Brown v. Commissioner, 706 F.2d 755, 756 (6th Cir. 1983);
Underwood v. Commissioner, 535 F.2d 309, 312 (5th Cir. 1976); Frankel
v. Commissioner, 61 T.C. 343, 347 (1973), aff'd, 506 F.2d 1051 (3d
Cir. 1974) (Table); Perry v. Commissioner, 47 T.C. 159, 163 (1966),
aff'd, 392 F.2d 458 (8th Cir. 1968); /4/ but see Selfe v. United
States, supra. Only when a shareholder-guarantor actually is called
upon to pay the debt he has guaranteed for the corporation does a loan
guarantee yield an economic outlay that increases his basis in the
corporation's stock. See I.R.C. Section 1012; Treas. Reg. Section
1.1012-1(a). In the words of the Sixth Circuit (Brown v.
Commissioner, 706 F.2d at 757), "guaranteeing shareholders must make
actual disbursements on the corporate indebtedness before they can
augment their bases for the purpose of deducting net operating losses
under Section 1374." As that court explained (id. at 756), "(a)bsent
such an outlay requirement, Subchapter S shareholders could readily
skirt the limitation embodied in Section 1374(c) * * * and thereby
erect a tax shelter that Congress undoubtedly never intended to
create." /5/
The courts below correctly rejected petitioners' contention that an
economic outlay from the shareholders to the corporation should be
imputed here by recasting the loan as one made directly to the
shareholders, followed by their contribution of the loan proceeds to
the corporation. It was the shareholders who determined how to
structure the loan transaction, and their tax treatment should be
governed by the transaction that actually occurred, not by one that
they might have entered into. In the words of this Court, they "must
accept the tax consequences of (their) choice, whether contemplated or
not, * * * and may not enjoy the benefit of some other route (they)
might have chosen to follow but did not." Commissioner v. National
Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974); see also
Don E. Williams Co. v. Commissioner, 429 U.S. 569, 579 (1977).
Moreover, there is no basis for rejecting the finding of both
courts below (see Pet. App. 10-11, 33) that the substance of the loan
in this case was fully consistent with its form as a bank loan
directly to the corporation. The loan proceeds were earmarked for use
in the corporation's business and were not placed at the shareholders'
disposal. Although the bank loan was shown on the corporation's books
and tax returns as a loan from shareholders, the corporation made all
payments of interest and principal with respect to the loans.
Moreover, neither the shareholders nor the corporation treated these
corporate payments as constructive income taxable to the shareholders,
as would have been appropriate if the loan in fact were from the bank
to the shareholders. See Pet. App. 19 n.19. Thus, the courts below
correctly held that petitioners made no economic outlay to the
corporation in the loan guarantee that would entitle them under
Section 1374(c)(2) to deduct a loss greater than the $10,000 that
Daniel Leavitt actually invested in the corporation. /6/
2. a. The court of appeals and the Tax Court correctly rejected
petitioners' argument (Pet. 13-14) that the question whether a loan
guarantee can increase the Section 1374(c)(2) limitation should be
resolved by resort to the principles that are generally invoked to
distinguish between debt and equity. This basic debt-equity analysis
is applied by the courts to determine the character of funds actually
advanced by a shareholder to a corporation. When the corporation is
not being taxed under the special provisions of Subchapter S (i.e., a
Subchapter C corporation), whether a shareholder advance is classified
as debt or equity has significant tax ramifications. /7/ But the
issue in this case turns on the amount of petitioners' advances to the
corporation, not the character of those advances. As the court of
appeals noted (Pet. App. 13 n.12), it is irrelevant in the Section
1374 context whether a shareholder advance is classified as debt or
equity, since the statute allows both debt and equity investments by
the shareholder to increase the limitation on deductible losses.
Thus, debt-equity principles are relevant only to what the court of
appeals correctly characterized as the second stage of a two-part
inquiry (see id. at 13-14) -- whether a shareholder advance should be
treated as debt or equity -- that is not germane to the tax
controversy in this case. Those principles shed no light on the
threshold issue, which is the one that is controlling here -- whether
the shareholder has made any form of actual investment in the
corporation.
b. Petitioners are correct in stating that the court of appeals'
refusal to apply the debt-equity factors in this context is at odds
with much of the Eleventh Circuit's reasoning in Selfe v. United
States, supra. As the court below stated (Pet. App. 19-20), that
opinion suggests that "debt-equity principles must be applied to
resolve the question of whether the bank actually lent the money to
the taxpayer/shareholder or the corporation" -- an approach that is
inconsistent with the analysis of the decision below. But this
disagreement does not warrant review by this Court.
The Eleventh Circuit's decision in Selfe does not irreconcilably
conflict with the decision below. First, as the court of appeals
explained (Pet. App. 19), the court in Selfe held only that the grant
of summary judgment should be vacated and the case remanded for a
factual inquiry into whether the loan was actually made to the
shareholder, rather than to the corporation. Here, by contrast, the
Tax Court found that the loan was actually made to the corporation.
For that reason, the court below did not view its decision as
irreconcilable with Selfe (see id. at 16 n.15). Second, as Judge
Williams noted in his concurring opinion in the Tax Court (id. at
42-43), Selfe is factually distinguishable from the instant case
because it involved a sole shareholder (and therefore there was
considerably less practical difference than here between a loan to the
corporation and a loan to the shareholders), whereas this case
involved a loan guaranteed by some, but not all, of the multiple
shareholders of the corporation. And finally, the statements of the
Eleventh Circuit in Selfe stand alone in invoking debt-equity
principles to determine the amount of the Section 1374 limitation on
the loss deductions available to Subchapter S shareholders; no court
has followed Selfe in this regard. See generally I. Grant & W.
Christian, Subchapter S Taxation Section 19.2 (Supp. 1989). Thus,
there is no assurance that the Eleventh Circuit would have reached a
result in this case different from that reached below. /8/
c. As the court of appeals explained (Pet. App. 12 n.11), the other
cases relied upon by petitioners (see Pet. 9-10, 16) plainly do not
conflict with the decision below. Both Casco Bank & Trust Co. v.
United States, 544 F.2d 528 (1st Cir. 1976), cert. denied, 430 U.S.
907 (1977), and Lane v. United States (In re Lane), 742 F.2d 1311
(11th Cir. 1984), involved the classification as debt or equity of
actual shareholder advances to Subchapter C corporations. Thus, these
cases were not concerned with the fundamental question here -- whether
Daniel Leavitt made any kind of actual advance to his corporation in
excess of $10,000. Similarly, both Plantation Patterns, Inc. v.
Commissioner, 462 F.2d 712 (5th Cir.), cert. denied, 409 U.S. 1076
(1972), and Murphy Logging Co. v. United States, 378 F.2d 222 (9th
Cir. 1967), involved guaranteed bank loans nominally made to
Subchapter C corporations, and the issue was the factual one of
whether the loan had in fact been made to the shareholder. In
Plantation Patterns, the court concluded that the loan, in substance,
had been made to the shareholder, and therefore he was charged with a
constructive dividend when the corporation repaid the loan. In Murphy
Logging, the court reached the opposite conclusion and refused to
charge shareholders with constructive dividends. Neither case
involved the limitations imposed by Section 1374(c)(2), and they have
no bearing here where the Tax Court found that the substance of the
loan matched its form, i.e., that the loan in actuality was made to
the corporation and hence did not represent any economic outlay on the
part of the shareholders.
CONCLUSION
The petition for a writ of certiorari should be denied.
Respectfully submitted.
KENNETH W. STARR
Solicitor General
SHIRLEY D. PETERSON
Assistant Attorney General
RICHARD FARBER
TERESA E. MCLAUGHLIN
Attorneys
OCTOBER 1989
/1/ The petitioners in this case are the Estate of Daniel Leavitt
and the Estate of Evelyn M. Leavitt, which is a party to this
proceeding solely because Evelyn Leavitt filed a joint income tax
return for 1979 with Daniel Leavitt.
/2/ If the corporation paid a debt that was personally owed by a
shareholder, that payment would be income to the shareholder as a
constructive dividend from the corporation.
/3/ Unless otherwise noted, all statutory references are to the
Internal Revenue Code of 1954 (26 U.S.C. (1976)) (the Code or I.R.C.),
as in effect during 1979, the year in issue.
/4/ See also Harrington v. United States, 605 F. Supp. 53, 56 (D.
Del. 1985); Wheat v. United States, 353 F. Supp. 720, 723 (S.D. Tex.
1973); Neal v. United States, 313 F. Supp. 393, 396 (C.D. Cal. 1970);
Borg v. Commissioner, 50 T.C. 257, 264 (1968); Raynor v.
Commissioner, 50 T.C. 762, 770-771 (1968).
/5/ For example, in this case Daniel Leavitt invested only $10,000
in the corporation but he claimed loss deductions in excess of
$13,000, even though he was not called upon during the year at issue
to make any payment with respect to his guarantee and, indeed, his
estate may never be required to do so.
/6/ Petitioners briefly suggest that their proposed approach of
allowing shareholder loan guarantees to raise the Section 1374(c)(2)
cap should be adopted because it is good policy; they argue that
guaranteed amounts are placed "at risk" and therefore should increase
the shareholders' basis (Pet. 9) and that this approach would treat
Subchapter S shareholders equitably as compared to limited partners in
a partnership (Pet. 20). Whatever the merit of petitioners' policy
arguments -- and one commentator has taken the position that the
statute should be amended so that loan guarantees relax the Section
1374 limitation (see I. Grant & W. Christian, Subchapter S Taxation
Section 19.7 (2d ed. 1980)) -- it is apparent that these arguments are
properly addressed to Congress, not the courts. Petitioners' "'hope'"
that this result can be achieved "'judicially rather than
legislatively'" (see Pet. 20, quoting 8 ABA Sec. of Taxation
Newsletter, Tax Commentaries 71 (Summer 1989)) is not consistent with
the role of the courts in our system of government.
/7/ For example, if a purported loan from a shareholder to his
corporation is determined not to be debt, but instead to be a capital
contribution, then interest deductions claimed by the corporation for
payments to the shareholders would be treated as nondeductible
dividends. Similarly, from the shareholder's perspective, amounts
denominated as (nontaxable) repayments of the indebtedness would be
treated as dividend distributions, which produce taxable income. See,
e.g., Estate of Mixon v. United States, 464 F.2d 394 (5th Cir. 1972);
Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968).
/8/ Indeed, even the court of appeals in Selfe stated that an
"economic outlay is required before a stockholder in a Subchapter S
corporation may increase her basis" (778 F.2d at 772).